Vince Lombardi, the famous Green Bay Packers coach, used to say there are three things that can happen when the quarterback throws the ball - a completion, an incompletion or an interception. Two of them are bad. Lombardi liked to keep the ball on the ground.
Stocks can only go three ways too: up, down or sideways.
Which direction is best? Do you hold on to your money and wait to “buy the dips,” or should you jump on the bandwagon and buy anything that’s going up?
Human nature is funny. Most people want their stocks to go up ten seconds after they go long, but not before. In fact, they love to buy stocks that are going down because that makes them “cheaper.”
When you buy a “cheap” stock, it is usually cheap for a reason. The market is saying the company is not as good as other companies with higher share prices. A $30 stock doesn’t fall to $18 unless lots of shareholders decide to sell and sell and sell.
Can that many people be wrong?
Sometimes. But more often than not, the herd is right. And even if they aren’t, the combined weight of their selling will pull the share price down.
Selling sets off a chain reaction - mutual fund managers don’t like to hold stocks that go down because they make the manager look bad. So they sell too. And many small investors either cash in their remaining paper profits or get out early to limit their losses. More selling.
Then the daytraders short the stock when it starts to break through support levels. Who wants to buy a stock whose chart is falling apart?
Buying a stock that’s going down is an exercise in faith. You have to believe that the stock will still make the earnings estimates that suggest a much higher “fair value.” You have to believe that the market in general will change its mind about the stock and start buying again.
And you may have to wait a very long time for the good times to return.
Another funny thing happens when people already own a stock whose price is falling through the floor. They decide to buy more.
The good angel sits on their shoulder and says, “You already lost $2000 in this stock, so cut your losses and move on. You know that’s the sensible thing to do. There are thousands of other stocks you can buy instead.”
But the gremlin on your other shoulder won’t give up. “C’mon, you wimp, if the stock was a good buy at $12, it has to be TERRIFIC at $8! Buy another 500 shares!”
So Joe Investor buys another 500 and watches the stock fall to 7, then 6 and maybe 5. This sequence of events usually ends with an earnings warning, the same warning that professional traders already knew about from the rumor mill. They bailed out a long time ago.
What about stocks going sideways?
The value calculation is the same. The market is saying, “Well, this stock ain’t bad, but it ain’t that great either. You may think it’s going to make $1.20 next year. So what? That’s only 10% over this year and we aren’t sure they can pull it off anyway. Plus stocks in this sector don’t get big PE’s - we save those for stocks like Microsoft and GE. We’ll pay damn near anything to own those two.”
The value stock you love at $12 may never go much higher than that, no matter how much you may adore it personally.
So what do you do?
Here is one approach. First, find a stock you like. It may be a great value, maybe you use their product every day, or maybe you think that everyone else wants to buy it just because it is going up so fast.
--If the stock is going up day after day without a break, buy at the open and set a 10% trailing stop loss order. Don’t try to outguess the tape.
--If the stock is going up and pulling back before it goes up some more, don’t try to guess how low the next dip will be. BUY THE STOCK THE NEXT TIME IT BREAKS OUT TO A NEW HIGH. That’s right, don’t try to buy the stock cheaper, buy it only when you KNOW it is going up again. Hitting a new high is a guaranteed indication of upward momentum. Set a 10% trailing stop loss order once you are long.
--If the stock is languishing in a trading range, don’t buy the bottom of the range unless you plant to flip the stock at the top. BUY THE STOCK THE NEXT TIME IT BREAKS OUT TO A NEW HIGH. You don’t want to own this turkey unless the upward momentum is back. Pay a few bucks more and be sure that the stock is finally going somewhere. And don’t forget the 10% trailing stop loss order.
Think about it - if your favorite stock is trading between $12 and $15 and you think it’s really worth $25, does it matter very much if you only buy it at 15 ¼? Your net profit is still a fat 9 ¾ instead of the 13 points you might have made buying the bottom of the range before a breakout.
But buying a breakout means your money won’t be tied up for months in a rangebound stock, and your 10% stop loss order means you won’t buy at 15 and still be holding when the bottom falls out and your favorite company is suddenly trading in single digits.
No trading system is guaranteed. But looking for breakouts instead of buying the dips is a high-percentage strategy when you do it right and stick to your rules.
Plan your trade and trade your plan.